Monday, January 27, 2014

The Only Reason for Automatic Dividend Reinvestment

Most readers might be aware that I do not automatically reinvest dividends in my taxable brokerage accounts. I usually have distributions accumulate up to a certain amount in cash, and then combined with fresh contributions I tend to purchase stock in companies which I believe to be good buys at the moment. That way, I am able to allocate my cash into the best ideas I can find at the moment.

I also do that because I do not want to buy partial shares in many companies regardless of valuation, through the automatic reinvestment of distributions. In addition, I avoid it, because it would be a nightmare to figure out taxable amounts, should I decide to sell the security. Imagine buying 100 shares of a stock like Phillip Morris International (PM), and then receiving the equivalent of one share every 3 months. Try doing this for 10 – 20 years, and now you have something like 40 – 80 individual transactions you need to take into consideration when calculating taxable basis, should you decide to sell.

As I have started accumulating funds in my tax-deferred accounts however, I am doing the exact opposite. For example, in my Roth IRA portfolio I started in 2013, I turned on the function to automatically reinvest dividends in the same security. I am using Roth IRA’s in this example because Roth’s have a fixed dollar contribution amount, and therefore this discussion could be relevant to more readers.

With $5,500 in annual contributions, the maximum amount of annual dividend income would be somewhere between $165 - $220. I could accumulate the cash for one year, and then purchase a security. Unfortunately, investing such a paltry amount in a locked account such as a Roth IRA would be prohibitively expensive. I have mentioned before that I do not want to spend more than 0.50% on commissions at a time. Even with a $4 commission, this equates to 2% on invested funds. If I accumulate cash from dividends to make a purchase where commissions are less than 0.50% of investment value, I might have to wait for almost four or five years. Therefore, it does not make much sense to accumulate a lot of cash in a portfolio to make one investment, unless of course no adequate investment opportunities are available.

The other reason for automatic dividend reinvestment is avoiding pressure. The pressure to select the perfect investment would be much greater, when you can only make one investment per year. I would have much more safety in my reinvested dividends, if I put them in several companies, as opposed to just one. This is because with $200 or so in annual distribution amounts, it would be prohibitively expensive to put distributions in several new ideas, versus reinvesting them back into the companies that paid them in the first place.

In addition, I am eligible to make contributions only once an year for my Roth IRA. This is because you can only put $5,500/year, and because of commissions it makes sense to invest the whole amount within two months or so. Thus, I would have to wait for several months, and accumulate cash for the annual contribution before I could make the contribution for the next year. Therefore the paltry initial amount of dividends (the $165- $220) could translate in accumulation of cash that is not helping in my long-term compounding of profits. I would be much better off in automatically reinvesting the dividends into the same security that paid them.

When you reinvest dividends immediately after receiving them, you are essentially starting the compounding process. This compounding process is particularly powerful when you reinvest dividends from a company that grows them over time. Your dividend will snowball and grow because of that. Waiting to reinvest for a few years, could prove costly in the long run. The only reason that you might not want to reinvest distributions automatically is if the underlying security is grossly overvalued. For example, if you owned Wal-Mart (WMT) stock in 1999 when it was selling for 30-40 times earnings, it would have been a crime to reinvest distributions back into the stock until the beginning of the Financial Crisis.

Once I accumulate the necessary scale however, the strategy could change dramatically. For example, if a Roth IRA generates $5,500 in annual dividend income, it would be essentially self-funding itself from distributions alone. If our dividend investor is also eligible to contribute $5,500 annually to the account, we would be dealing with essentially $11,000 available to invest throughout the year. If we can keep commissions to $4/trade, we can potentially make as many as 13 – 14 transactions/year. Therefore, it might make more sense for this account to accumulate cash from distributions and contributions only after sufficient scale is achieved. Then the money would be used to allocate into an attractively valued security at the time, one investment per month or so.

To summarize, it might make more sense from a cost/benefit perspective to automatically reinvest funds in the same security, if you do not have a large portfolio. However, once you reach a certain scale, it might be best to accumulate distributions in cash and then make investments at the best values you can find at the time. Because I am building up my scale in tax-deferred accounts right now, it makes sense to reinvest automatically there. For taxable accounts however, I group dividends received with contributions, and allocate the money in the best opportunities at the moment.

23 comments:

Hello, and greetings from Finland! I have been using broker from USA for a month now. Although my fees are about same, $120 in a year, I can do a lot more purchases with same amount of money. Earlier I could buy one stock every three months because one transaction costed me 15€. Now with new broker, I change currency once a month and do 11 transactions, all this with $10 in a month. I think this is good in sense of diversifying company and time risk.

It's actually not as complicated as one might think. The average cost basis is used and "multiple dates" is listed as the purchase date. The brokerages provide this information for you. Of course, since my holding period is forever, I don't plan to sell many of my reinvested shares.

Interesting comments. If an investor is interested in automatic reinvesting, but is deterred by the calculation of basis over many years, I would recommend some type of financial software to assist. I use SEE Finance and it is great. It tracks personal spending, but handles investments well. But there are many other options as well. With software help, I don't think the basis issue is too big of a deal. Of course, there is the issue of software becoming obsolete over many years, but there are ways to port data from one program to another as the need arises.

This is really helpful to me as someone who right now is reinvesting 100% of my dividends. I do agree with your argument about a small portfolio vs. large portfolio. I think whenever I'm generating enough dividend income to be able to make multiple investments per year at a reasonable rate, then I will reconsider my position on reinvesting.

I don't see why there should be pressure to pick just the right investment in your Roth IRA. You are looking at it wrong. Your Roth IRA is just one account in your investment portfolio. It just happens to have its own account number. You don't sweat picking any one stock in your taxable account, now do you?

Yes, agreed interesting topic.I do mostly DRIP. But when a company is overpriced, I switch to getting cash direct deposit to my checking to fund purchases. When the stock price declines to more reasonable levels, I switch back to DRIP purchases.Also if a company's DRIP fees are too large, I just get direct deposit to my checking to fund purchases.

I track all my investments, and the dividends, and purchased shares (direct or DRIP) in a spreadsheet on my PC. So it's relatively simple to get the exact gain and loss for any sale with just a few clicks.

Most brokerage firms figure the average cost of your dividend reinvestments over time(including your original investment plus additional purchases and sales during the time that you owned the security) this tkes the headache out of figuring for tax purposes.

I'm going to have to disagree with you here. The main advantage with a DRIP or synthetic DRIP is to gain access to dividend reinvestment discounts. Personally, I only synthetically DRIP companies that offer a discount. The rest are taken as cash or FRIPed if held in my Scottrade account. However, discounts are kind of rare as I'm sure you know.

I understand your point about IRAs or other accounts that have deposit limits. That makes sense.

Turbo tax's import feature surely makes multiple small purchases a moot point. It will do it for you.

I do not care if I am right or wrong. All I care about is making money. Also, if you do not know the reasoning on why each of my accounts, both taxable and tax-deferred accounts need to be individually diversified, just ask why. Do not assume you know all the answers to my investing.

For everyone else who commented on the article - thank you for your time.

I agree that it is easier these days to track purchases and sales with software. However, it is much more labor intensive to track cost basis of 80 transactions, versus say 8 or 10. It is painful to keep track of investments for 20 years, since things do change, computers do crash, programs become obsolete, brokers do go through changes as well. For example, I have used Zecco since 2007-2008. It merged with Tradeking a couple years ago.

Now all my purchases done before 2011 are lumped as if they occurred in 2011, for cost basis. Luckily, I have my data downloaded in spreadsheets, so if I sell, I can calculate gain/loss, and provide specifics.

Of course, the thing to keep in mind is that when I write things, I write about things that are true for me and come from my experience. I am very manual in everything, so maybe I need to streamline myself a little. I guess something for me to consider.

Good luck in the dividend investing journeys. The goal is to learn from each other, but also to find the style that works individually for you.

Perhaps I didn't explain what I meant very well. In general, I think DRIPs are not that great because you have no control. That's why 95% of my companies are not automatically reinvested. I'm agreeing with you on that.

However if a company offers a discount then it makes sense to take advantage of it. I'm looking at WTR and it offers a 5% discount. Pretty nice. I think that is the best reason to consider DRIPing a stock that you want to own anyways. (Haha I'm not saying to only consider stocks that offer discounts)

DGI,You got a lot of feedback on this. I do both. My DRIPs I have always diligently tracked every transaction on a spreadsheet so I have the data, and yes, the ones started after 2011 should do it for you. When I have sold older positions, it is kind of a pain.

I currently reinvest everything in my DRIPs, however, for some of the larger holdings I'm thinking about taking the cash and moving elsewhere. Especially VZ. KO and CVX I'll keep reinvesting. GOod piece.-RBD

It is sometimes tough to communicate exclusively online, as a lot of information could be lost "in translation".

I get what you are saying about DRIP discounts - they are pretty nice. I mean if you have a decent yield, growing dividend and a drip discount, you are really compounding even faster! I would probably have to look at WTR.

I use USAA as my broker and not everyone can do that. Their fees to me are only a buy or sell commission. They end up being my book keeper and their reports tell you all you need to know about your basis. They send a end of year report at tax time. I am a hold for ever guy but do sell a stock to buy another I feel improves my investments. I do not like the thinking required to time or pick the investment of dividends, so I am an auto investor on that point. I am happy to have more shares of any stock I own. When that becomes untrue, I sell all the shares and pick a new stock or invest in others I own. Sounds simple and it is. thanks for all you do to help us probies. Hwood007

1)You can gain access to dividend reinvestment discounts.2)You get some dollar-cost averaging.3) No commission fees.4) Take advantage of compounding.5) DRIPs can help take the emotion out of investing.6) DRIPs can be a “set it and forget it” retirement plan once you have many stock holdings.

The thing is as well, you can use the leftover cash from the DRIP, accumulate that cash, and use that cash for more stock purchases.

I handle my Roth the exact same way as you have outlined. Once enough cash is generated within it, I will target my investments to better valuations, until then dividends will be reinvested. A few years ago I sold a stock held for about 20 years, dividends were reinvested the entire time. In that time, there had been a merger, a split, and I changed brokers. Preparing to see my accountant and talk about this was indeed a nightmare that will not be repeated. These days I consider too how my loved ones will contend with such things if I become ill or in my estate when I'm gone. I now try to make these tax issues easier for me, and for them.

Wow, definitely a popular post DGI! For me, I am currently in a position similar to the one you describe with your IRA. Until I reach $2-3,000 of dividends per year in an account, I will continue to DRIP. Just a matter of limiting how long the cash will be sitting there if I'm unable to consistently add fresh capital due to other investments or life needs.

I really appreciate the work you do and your ongoing analysis. But if you're practicing your investing strategy in a retirement account (401k) for example, doesn't it not matter whether or not you can calculate cost basis? You're not paying any tax on the gains, only paying tax when you start to withdraw money from these accounts as income. So DRIP investing makes great sense in these accounts. That's what I do. It definitely takes the pressure off. And, there are no brokerage commissions either. My broker just automatically buys more shares with the dividend for free.

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